Saturday, May 24, 2008

Inflation - undertstated (2) - the implications

In part 1 of this post I made the point that CPI type indices which are typically used as proxies for inflation tend to understate the true rate of inflation. If inflation is understated this has a number of potentially significant implications for investors and for personal finance more generally. From a personal finance perspective, underestimating the rate of inflation on your future expenses can result in a significant underestimation of those future expenses. Try calculating the difference between household expenses growing at 4% pa compared to 3% pa over a period of 30 years.

Understating the true rate of inflation also has implications for investments. Bonds and deposits will be overpriced as a result. Inflation indexed annuities and bonds will also be overpriced. All of these instruments will show real rates of return lower than expected. Given that the nominal rate of return in bonds and deposits is very low already, the real rate will be even lower. In many countries it will be negative.

Equities I am less sure about. History suggests that equities are a better investment that bonds in times of inflation. However, pricing is often at least partly done on a comparative basis. If bonds are overpriced this may suggest that equity prices have also benefited from that mispricing as well. Similar arguments can be made in favour of real estate and commodities and just about any asset class.

Debt is under priced. In Hong Kong we have negative real interest rates already. An upward restatement of the rate of inflation would increase the size of the negative margin.

While I do not expect governments to restate inflation numbers any time soon as they need to (i) inflate their way out of massive deficits and debt levels and (ii) do so while managing inflation expectations, growing awareness of how unreliable and inaccurate CPI indices are has the potential to cause changes in the way people invest. Hard assets such as real estate, commodities and collectibles will become more in demand. People will become more reluctant to hold assets that do not at least have the potential to keep pace with inflation.

The biggest question of all is whether central banks will keep interest rates low in an attempt to stave of a recession or raise interest rates to try and cool inflationary pressure (which they are creating by inflating the money supply). My betting is largely on the former (at least until we see signs of an economic recovery). If this is right, then using debt to invest in assets such as real estate and equities is a logical investment strategy.